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Ad-based versus direct monetization: Which one is better for you?

Well, it turns out that Star Wars fanatics are easier to monetize, but are harder to find at scale!

More recession talk = More interest in direct monetization
There’s always discussion about the weaknesses of ad-based revenue models for consumer internet, and with recession chatter increasing every day, many companies are turning to freemium based models. Silicon Alley Insider recently wrote about this in an article called Revenue Crisis: Here Come The Pro Accounts. And of course, there is constantly discussion around the example of 37 Signals, who are notable critics of business models that give away product for free, described by the the Techcrunch article 37 Signals Drives Another Company To The Deadpool. Here’s another from Slate called A Radical Business Plan for Facebook: Charge people.

Direct monetization models versus indirect monetization
To restate the general argument in my own terms, there are basically two kinds of companies on the internet (and btw, I’ve discussed these two groupings of companies at my talk at Startonomics – you can check out the video here and the slides here):

  • Direct monetization, aka Advertisers: Direct monetizers charge money for their products, via subscription, ecommerce, virtual items, etc. They typically have a small, focused group of customers.
  • Indirect monetization, aka Publishers: Indirect monetizers don’t charge money to use their product and in fact, often give their product away. They chop their audiences into pieces (using content to differentitate between them) and sell the targeted audiences to companies who directly monetize them.

Now note that Direct monetizers and Indirect monetizers have very different problems:

  • Direct monetization: The biggest issue is cost per acquisition and limited size of their customer base.
  • Indirect monetization: The biggest issue is zero cost user acquisition and identifying user intent (via targeting)

And of course, the central issue is that direct monetization has the huge advantage that you can “make money as you go” and maintain a profitable trajectory at every point. This is great for the bootstrapped startup.

Compare this to the indirect monetization companies which often need to reach a very large critical mass, burning lots of capital along the way, until it gets large enough to sell their audience segments in large enough chunks to be interesting to advertisers.

From the venture capitalist’s point of view, the indirect monetization models are often able to produce larger exits, and thus the “go big” mantra holds here. The reason is that the indirect monetization methods are often appropriate for companies who have extremely horizontal audiences (like search, email, video, etc.) combined with viral growth.

From the VC’s perspective, the direct monetization models can often be less desirable because they may have a small customer base that can only be reached by expensive marketing techniques. As a result, there ends up being a smaller exit because the startup exhausts all their marketing channels to reach their customer base and may not be able to grow beyond that. This is why, although it may be highly profitable to build software for orthidontist offices, these companies often end up lifestyle businesses and not venture-returns businesses.

Which one are you?
I want to stop here and ask, which method best suits your company? I’ve found that there are several Web 2.0 companies floating out there that should probably charge for their product because they are niche products, but instead they are opting to go free and ad-supported. This may be a mistake. Similarly, there are products out there with wide audience appeal that may generate more revenues as indirect monetization models (for example, much of digital content).

Both strategies work: Compare MySpace versus World of Warcraft
Ultimately, this is an optimization of two variables simultaneously. One variable is the size of the audience, and the other is the revenue potential.

The tension is that:

  • Size of audience is determined by breadth of appeal
  • Revenue potential is driven on intent and passion of audience

Oftentimes, of course, these two variables are at odds. It’s the rare product that EVERYONE will pay for, and often you have to choose between monetizing a small group of fanatics at high rates, or monetizing a huge group of casual users at low rates.

The two corners of this model, of course, are MySpace and World of Warcraft.

  • MySpace is an amazing indirect monetizer – they have a HUGE audience, but but make very little money off of each user. Even with 10s of millions of uniques, they make cents per user per month. But this all adds up to nearly $1B in revenue per year. Note that the first version of MySpace was relatively cheap to build (hey, it’s just a website!)
  • World of Warcraft is an amazing direct monetizer – they have a much smaller audience (<15M subscribers) but make a ton of money off of each user. They charge a $15/month, and even with their much smaller audience they make nearly $1B in revenue per year. Note that the first version of WoW was quite expensive (into the 10s of millions!)

The point is that both strategies work – the question is, what can you learn from each of these to figure out which model works best for you?

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